Friday, January 27, 2012

Remember a term sheet agreement is not a deal until the check clears. Entrepreneurs sometimes assume an initial agreement with an Angel is a commitment, so they start spending before any money is received. But due diligence and paperwork take time, and can change everything.

It’s true that Angel investors typically do not present entrepreneurs with overly complicated deal structures, especially when compared to venture capitalists. However, there is no set pattern of terms an entrepreneur might be able to anticipate from either. Your best strategy is to bring your own term sheet to the negotiation as a starting point.

When a company is at its earliest seed stage, the terms tend to be the least complex. As the company grows and the second or third group of investors comes in, the terms of each subsequent financing grow in size, scope, and the number of lawyers’ fingerprints on them.

Based on my experience, and the book “Attracting Capital from Angels” by Brian Hill and Dee Powers, here are some key clauses that any investors expect on the first term sheet for the investment you need:

Set the price. The price is the percent of ownership given to the investor, calculated as “investment/post-money valuation.” The pre-money valuation is company value today, while the post-money valuation is the pre-money valuation plus the investment amount.

Seat on the board. This does not mean that if you have eight Angels in your company, you will have to seat all eight of them on your board. But the lead Angel would certainly ask to be given a seat.

Define equity type. The first capital a young company receives usually takes the form of common stock, the same class of shares the founders hold. Venture capitalists and later round investors like the preferred convertible shares.

Outline multiple tranches. Investors may provide money in stages or tranches, based on defined milestones, to decrease investment risk. These “IV drip” financings may reduce risk for investors, but put more pressure on founders.

Anti-dilution protection. This clause attempts to protect the conversion price of stock of Angel investors, prior to additional financing, from being reduced to a price equal to the price per share paid in a later “down” round. But some dilution is almost inevitable.

Right of first refusal. Angels may want the first right to purchase shares held by the other angels in the deal before they are sold to an outside party. This allows a committed Angel to consolidate his ownership, rather than see it scattered to the wind.

Liquidation preference. These are terms which basically say for the investor, “give me the option to get my investment back or my negotiated ownership, whichever is more”. It prevents the entrepreneur from selling early, at a loss to the investor.

Remember that due diligence and negotiation takes time. Not allowing enough time is one of the major mistakes made by entrepreneurs. You can end up becoming very frustrated with the investors, or cause the venture to fail if you run out of seed capital before the angel round can be completed.

In a survey for the above book, Angels reported that it takes them an average of 67 days to close, while the average closing time for venture capitalists was 80 days. This time does not include finding the right angels, which is the first and longer part of the effort.

You should expect that both parts, when combined, can take three, six, or nine months – or more. Don’t wait till your last dollar is gone before you start looking for the next one. The check won’t clear in time to save you.

Major factors to be considered in the valuation (management team, size of the market, successful business model, revenues, customers, disruptive technology, patents, copyrights and trade secrets, distribution channels, lack of competition, etc.) should be listed in order of importance and a value assigned to each (e.g. management team could be worth 30%). Whatever you do, never ever leave the valuation solely up to the investor or enter into a discussion with any angel investor or VC firm without a business valuaton. All business valuations are open to negotiation. Never pad your business valuation in order to raise a higher amount of apital. Investors will see right through that, and walk away.